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China stocks take step forward with MSCI nod

Dan Martin

Equities index compiler MSCI will on Friday include mainland China-listed companies on its benchmark indices, giving many foreign investors their first exposure to Chinese shares.

The decision last year by MSCI to add more than 200 firms was seen as a victory for Beijing, which has pushed for years to have its equities recognised, as leaders look to expand the country's global market influence.

The MSCI indices track constituent companies' performances, which are then used as a guide for cash-rich foreign institutional investors (FIIs).

Following are answers to key questions on what this means for China and foreign investors.

Why did it take so long?

US-based MSCI has for years resisted adding China-listed stocks -- or "A-shares".

Concerns included Chinese government meddling in business, murky corporate governance, and difficulties foreign institutions faced buying shares in China's walled-off markets.

Then there's the volatility caused by the millions of unsophisticated small investors who drive most trading with often bizarre "buy" decisions, such as a surge in companies whose names resembled North Korean leader Kim Jong Un's when he visited Beijing in March.

So why now?

China has been gradually opening the door to its huge $7.4 trillion equities market -- the world's second largest after the US.

Beginning in 2014, foreign investors have been able to buy some Chinese-listed shares via so-called "stock connect" trading conduits linking Hong Kong's more open market with those in mainland China.

These and other steps convinced MSCI that mainland China stocks should be represented in its benchmark indices.

How will it work?

Foreigners could already buy shares of big-name Chinese firms that listed overseas, such as Alibaba, Baidu and Tencent.

But MSCI will add around 234 domestically listed Chinese big-cap stocks to its emerging markets and China indices, which will likely encourage FIIs to add such shares to their portfolios.

They include heavyweights like Kweichow Moutai, the world's largest distiller, automaker SAIC and consumer appliance giant Midea.

But MSCI is being cautious: Chinese A-shares will initially represent only about 0.39 percent of the emerging market index's weighting and the level is expected to remain miniscule for a long time.

Will money start flowing in?

MSCI inclusion does not automatically trigger fund flows.

But FIIs that sell mutual funds and other products which track MSCI indices will most likely begin purchasing shares of the relevant companies to stay in step with the US index compiler.

MSCI expects an initial infusion of $17 billion into the newly benchmarked Chinese companies, doubling in coming years, while others such as Citibank have projected up to $48 billion in annual inflows.

What's the upside?

Markets hope the greater foreign attention and expected increase in research and analysis of the relevant Chinese companies will nudge them toward Western governance standards, transparency, and accountability.

"The quality and the expectation for what the corporates are willing to share is going to change. That's got to be good for markets," William Greene, Morgan Stanley's director of Asia research, told Bloomberg News.

Analysts also predict MSCI's endorsement will encourage more stable Chinese and FII investment in such shares, sidelining the volatile rumour-driven trading that often prevails.

Foreign investors, meanwhile, will in theory have greater opportunities to profit from Chinese growth through shares such as liquor giant Kweichow Moutai -- which tripled in value the past two years.

But those gains will remain tiny until China's MSCI weighting is substantially raised, which is considered inevitable but expected to take time.

What's the downside?

The puny initial weighting is a clear sign of MSCI's wariness to fully embrace a corporate landscape prone to scandal and heavy-handed government intervention.

"The risk for both sides is that China may not yet be ready," said Brock Silvers, managing director of Shanghai-based investment advisory Kaiyuan Capital.

"Chinese corporate scandals are regular occurrences, and foreign index investors may now be welcoming the next one into their portfolios."

Silvers said rather than improve corporate governance, MSCI's imprimatur may do the opposite.

"Inclusion would be extremely hard to reverse, and the pressure to increase the allocation will be enormous. MSCI inclusion may have unintentionally reduced China Inc's pressure to reform."